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What Is an Economic Bubble?

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  • Written By: Mary McMahon
  • Edited By: Nancy Fann-Im
  • Last Modified Date: 08 November 2016
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An economic bubble is a period of rapidly increasing values for assets that may outstrip their real value. As the market corrects, the bubble bursts, and the values crash. The cause of an economic bubble is typically runaway speculation. It is often difficult to identify as it occurs, and people may spot it only after the bubble bursts and they can retroactively evaluate the worth of assets. If an economic bubble is large enough, it can cause significant problems across the economy as a whole.

One of the most remarkable economic bubbles in history occurred in the 17th century in Holland. Dutch traders began trading tulips at increasingly high prices, particularly for very rare specimens. Single bulbs could sell for many times the annual income of a skilled artisan, until prices crashed extremely rapidly in 1637. Speculators who had not been able to get out of their investments in time faced staggering losses, and farmers who had sunk substantial resources into tulip cultivation suddenly had worthless assets.

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Real estate is often involved in economic bubbles, as is technology. Several bubbles inflated and burst in the late 1990s around the world in response to trends surrounding technology and real estate. In all cases, investors and speculators involved in the inflation of the bubbles believed that the sky was the limit in terms of asset values. This triggered a very aggressive market where assets could increase substantially in value over the course of a single day, and a frenzy of buying and selling would occur. When the speculative haze cleared and prices dropped, substantial losses occurred.

With real estate, one consequence of an economic bubble can be a ripple effect across the financial industry. As property loses value, so do the mortgages and derivative products attached to it. Lenders with large loan portfolios that rapidly decrease in worth may go bankrupt. This in turn can trigger panic among investors and account holders and may cause the problems to spread across the economy. With less money available for lending due to losses, the credit market can also dry up, and this will make it difficult to stimulate the economy into recovery.

The processes behind the formation of economic bubbles are a topic of study and intense interest. Economists want to be able to predict them and spot them as they occur. They can use a variety of tools to filter out the signal from the noise when it comes to price fluctuations and investor behaviors. These can help distinguish an economic bubble from a genuine increase in value, but they are not entirely reliable.

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donasmrs
Post 3

@bear78-- The same kind of economic bubble occurred before, in the 1920s if I remember correctly. Unfortunately, we do continue to make the same mistakes. The biggest issue has always been the use of borrowed capital to increase the profits of a good. This can be the housing sector or any other sector. When a good is leveraged to the point where it has far exceeded its value and borrowed money is involved, the result is a bubble.

bear78
Post 2

@turquoise-- It's not so easy to predict it but we do have some good examples in our recent past such as the US "housing bubble" in 2008.

Basically what happened there was that interest rates were lowered and people started buying a lot of houses. But banks became sort of greedy and started giving out loans to even consumers with little or no credit. So when interest rates and consequently mortgage rates suddenly went up, people couldn't afford to pay and lost their homes. Banks who couldn't get their money back went bankrupt.

So although the value of the housing market appeared to rise suddenly, it was a bubble and it burst. I do hope that economists and policy makers prevent the same sort of thing happening in the future.

turquoise
Post 1

I'm not an economist and I may not be right about this. But don't economists, investors and buyers have a general idea about the cost of a good? I mean, if the price rises suddenly to unbelievable levels, isn't that a good sign that it's an economic bubble?

I mean, as it happened with the tulip bubble, how can tulips possibly cost? If the market could regulate itself and take action before the bubble bursts, then some of the damage could be prevented right?

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